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Capital, Investment, and Saving

By Cheryl Riley,2014-08-11 22:28
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Capital, Investment, and Saving

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    Capital, Investment, and Saving

    (Sloman 5e page 450 box 16.3)

    (Sloman 6e page 438 box 15.2)

    National Saving sum of private saving and government saving (budget surplus)

     Private Savings = personal savings + business savings

     Personal savings - allocate DI between C & S; pension funds, insurance,

     savings

     Business savings retained profits and pension funds (also self-insurance

     funds and the like)

Important influences on household saving decisions (small part of total

     savings in US as it was 0.9% of total in 2004)

    1. real interest rate opportunity cost of consumption, interest

    forgone (movement along savings curve)

    Shifts of savings curve caused by:

    2. disposable income greater DI then the greater S

    3. wealth household’s assets minus its debts; greater wealth,

    less S

    4. expected future income lower future income, greater S today

    a. income is the flow of money (or purchasing power) per

    unit of time derived from the use of human or property

    resources

Young people and retired people save the least. Why?

     Young higher future income

     Retired less DI means less S and they spend their savings to live

     Middle aged save the most

    Although changes in the real interest rate (movement along the curve) bring changes in saving, most of the changes in saving result from changes in the three factors that shift the saving supply curve. (relationship between S and real i)

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     Savings

     %

    Real i

     0 Q

     Savings ($billions)

Rising disposable income raises saving supply and saving supply influences

    investment

Role of Government

    Real interest rate is determined in the world capital market

     aggregate investment and aggregate savings of all governments matter

     savings of all governments is about 10% of world total savings

     direction of world total government savings is negative

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    3

     World Capital Market

    %

    Real i

     0 Q

    World Savings and World Investment ($trillions)

    Greater real I, greater is SS (Saving Supply) and less is ID

For a closed economy (to ignore X): n

GDP = C + I + G expenditures

GDP = C + S + T income

C + I + G = C + S + T set equal - substitution

I = S + (T G) rearrange

    Note: European governments generally account for G in two categories: 1) government expenditures (operating) and 2) social capital investment

I = S + T G, therefore:

    ; If net taxes (T) exceed government purchases (G), government

    has a budget surplus and government saving is positive

    ; If government purchases exceed net taxes, government has a

    budget deficit and government saving is negative (dissaving)

    ; total world saving = total private saving + total government saving

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    ; Effect of negative government saving is to decrease world saving

    supply and increase the real interest rate; investment decreases;

    crowding-out effect

    ; Crowding-out government budget deficit forces government to

    borrow, competing for funds thus crowding-out I. SS shifts to the

    left and the quantity of Investment decreases.

     Crowding-out Effect on Savings

     %

    Real i

     0 Q

     Saving and Investment ($trillions)

Business I decisions influenced by:

    ; Expected after-tax profit rate shifts ID curve; influenced by

    phase of the business cycle, advances in technology and taxes

    ; Real interest rate opportunity cost of I whether funds are

    borrowed or are from retained earnings

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    Ricardo-Barro Effect

    thDavid Ricardo, 18 century English economist

    Robert J. Barro Harvard economist today

    States that government budget deficit has no effect on the real interest rate or investment; financing government purchases by taxes or by borrowing are equivalent

Reasoning:

    1. government sells bonds to cover deficit due to shortage in taxes

    2. government pays interest and must collect more taxes in the

    future to pay the interest

    3. taxpayers are rational and have good foresight

    4. taxpayers realize taxes will increase in the future and that their

    disposable income will decrease

    5. with a smaller expected future disposable income, private saving

    increases (indirect effect of government deficit)

    6. to neutralize effects of government deficit, taxpayers are

    induced to increase saving by same by same amount government is

    dissaving

    7. real interest rate, total saving, and investment remain constant

    Taxpayers probably respond in the direction of the Ricardo-Barro effect, but not in the amount that they suggest so the strength of the Ricardo-Barro effect is what is of value

Reality? probably somewhere between the two extremes

     Ricardo-Barro Effect

    %

    Real i

     0 Q

     World saving and World investment ($trillions)

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    Savings and investment in the national economy

    S and I are equal in the world economy but not necessarily in the national economy

    In a nation, I is financed by national savings and borrowing from the rest of the world

Nation’s international lending equals its exports

    1. a net export surplus means the nation lends to the rest of the

    world

    2. negative net exports means the nation borrows from the rest of

    the world

     Savings, Investment, and International Borrowing

     (national curves)

     %

    Real Interest Rate (% per year)

     0 Q

     Investment and Savings (trillions 2004 dollars)

    Example: US international borrowing has increased because US

     investment has increased and US national saving has decreased

US national savings is less than US national investment. Since In < Sn,

     the US borrows from the rest of the world

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    In 2004, US household saving was 0.9% of income

    In 2004, total national saving in US (household, firm, and government) was 14.7% of national income

    The greater government saving, ceteris paribus, the greater is national saving and the smaller is international borrowing (or greater is international lending) shifts SS curve to the right

An increase in a government’s deficit decreases national saving and

    increases international borrowing shifts SS curve to the left

    Because capital market is a global market, US government deficit does not necessarily crowd out US investment since borrow abroad but it

    does influence (raise) interest rates

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